Business Cycles

An economic model illustrating

 

increases and decreases in a nation’s

 

real GDP over time.

As we have seen the fundamental economic problem is one of scarcity. There are insufficient resources, globally, nationally and personally to meet all our needs and wants.

Priorities need to be determined and choices made, nationally and individually.

Not making a choice also carries a cost, a lost opportunity.

In a highly specialised economy, your income determines your ability to consume, and income (and ‘wealth’ – a store of income in the form of assets) are unevenly distributed.

Australia is a modified, free enterprise economy.

Economies lie on a continuum from total laissez-faire, free market, unbridled self-interest to the other extreme of centralised planning and control.

While the profit motive and self-interest are driving forces in the decisions about what, how and for whom to produce in Australia, the government plays an active role in regulating, enforcing and incentivising economic decision making and alleviating the most severe excesses of the system.

The market is efficient; the interaction of supply and demand allocates goods and services highly effectively through the rationing device, we know as the price.

In a perfectly operating market, as demand for particular goods rises, supply expands to meet the demand. If supply cannot meet the rising demand, prices rise to distribute the available stock. The reverse is also true. If demand for a good or service falls, producers will run down their inventories and cut back on production, perhaps even cease production and prices may fall. Resources are then free to flow into the production of alternative goods and services.

That’s the theory!

It is, however, a simplistic, textbook version of the economy and relies on the assumption that a ‘laissez-faire’ (meaning to leave alone) strategy is best. It relies on ‘perfect competition’ – but perfect competition is conditional on ‘perfect knowledge’ (amongst other things) which empowers consumers to efficiently ‘shop around’.

In reality, many factors come into play that may inhibit the free operation of markets. Supply is not always perfectly ‘elastic’ or responsive to the heightened demand for a particular good – rather than increased supply; we may simply end up with higher prices for the same product or service. If this happens in a general and consistent way, we simply get inflation, and our buying power erodes.

Microeconomic reform is designed to address the inelasticity of the supply side of markets, making them more responsive to demand-side changes.

So, while the market system may be efficient in many ways, it is not necessarily equitable, nor is it always self-correcting!

Modern economies, like Australia’s, are subject to market failure.

The government in Australia manages the economy and its failings through a combination of macroeconomic policies designed to smooth out the worst extremes of the business cycle – the regular periods of instability accompanied by inflation at its peak and unemployment at its trough.

Fiscal Policy influences the economy through budgetary and taxation measures. When the economy is slowing, and unemployment is rising, the government can inject money into the economy by running a budget deficit = spending greater than revenue. (injections > leakages*)

When the economy is overheating, and inflation is rising, a surplus budget will dampen demand and put downward pressure on prices. (leakages>injections)

Remember that every policy decision has trade-offs and unintended side effects.

Running a surplus may reduce inflation, but it may also mean the loss of jobs. Running a deficit may employ more people but at the cost of higher prices.

Nothing is simple or straightforward!

Remember the circular flow of income model or the ‘above ground pool’ analogy? The size of the pool and therefore, the number of people who can get in and get wet depends on the balance between leakages and injections.

In the national income equation Y= C + I + G + (X-M)

The ‘G’ is Fiscal Policy which aims to maintain the level of the water in the pool but it is also deliberately formulated to incentivise participation and enterprise and encourage self-sufficiency.

Tax concessions, grants and exemptions are provided by the government to encourage property investment because of its significant contribution to incomes, output and employment directly and indirectly via the multiplier effect on the economy as demand for complementary goods and services rise in accord with housing construction. Property investment also provides a means of building wealth and reducing future welfare costs and so incentives are deliberately designed to encourage planning, entrepreneurship and self-reliance.

The government also depends on the Reserve Bank’s implementation of Monetary Policy to help even out the ups and downs in the business cycles.

Monetary policy involves setting the interest rate on overnight loans in the money market (‘the cash rate’). The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation. In determining monetary policy, the RBA has a duty to maintain price stability, full employment, and the economic prosperity and welfare of the Australian people. To achieve these statutory objectives, the Bank has an ‘inflation target’ and seeks to keep consumer price inflation in the economy to 2–3 per cent, on average, over the medium term. Controlling inflation preserves the value of money and encourages strong and sustainable growth in the economy over the longer term. https://www.rba.gov.au

Interest rates are eased to encourage spending and growth and therefore, employment and tightened to control inflation.

Through a combination of Monetary and Fiscal Policy,

governments aim to even out the extremes of the business cycle.

 

We are living through an unprecedented crisis and are almost certainly headed for a recession – defined as two consecutive periods of negative growth, something Australia hasn’t experienced for nearly three decades:

The latest release of the Australian National Accounts reported the 110th consecutive quarter since the Australian economy last faced a recession. This achievement represents the most prolonged period of growth without a recession for a developed country since the System of National Accounts was introduced internationally following World War II.

27 years and counting since Australia’s last recession

What is different about the current situation is that the downturn in activity and confidence is not a result of an economic or financial shock but a viral pandemic. The risk of a recession is real, and there are no precedents to call on to to be able to accurately predict how long it may last or how deep it may be. Unemployment lines are the first sign that we are in a precarious situation, economically and socially.

HOWEVER, THERE ARE SOME DIFFERENTIATING FACTORS TO KEEP IN MIND:

  • The Reserve Bank of Australia has reduced the overnight cash rate to a historic low of 0.25% and has stated that they are prepared to engage in quantitative easing – a first for Australian Monetary Policy. It involves buying back government bonds and semi-government securities to inject cash into the economy.
  • The Federal Government has approved expansionary Fiscal Policy of an unprecedented scale to ‘pump prime’ the economy through various measures to support businesses large and small and to help soften the landing of the impact of the sudden exit of thousands from the job market. The size of the stimulus is also unprecedented in magnitude and reach, with the government stating they will ‘do whatever it takes’ to keep the economy from imploding.
  • While several industries and their workforces have been decimated, others are thriving, and some employees can transition to new sectors where job creation is happening rapidly( retail workers being redeployed to Centrelink offices, hospitality workers employed by supermarkets and logistics)
  • Australia’s economic fundamentals before the crisis were strong, and we should bounce back strongly once an end is in sight for the COVID 19 pandemic.
  • Scientists are working on developing treatments and a vaccine, and once they are viable, the confidence of consumers will be boosted significantly.